This guide describes how each ratio used in the BLTR is calculated, what its analytical purpose is and issues to consider when interpreting the ratios.
Users should also refer to the ‘Key Concepts’ guide as this provides considerable background to the use and interpretation of the ratios.
Four capital-related ratios are shown in the BLTR, each calculated twice.
The initial display is based on ‘reported shareholders’ funds’ (RSF) and the second on ‘adjusted shareholders’ funds’ (ASF). The rationale for these alternative calculations is covered in the ‘Key Concepts’ guide and in the ‘Data Adjustments’ note.
Shareholders’ funds represent the insurer’s ‘risk capital’ (the capital deemed available to absorb financial losses not already reserved or otherwise accounted for). The capital ratios therefore show the scale of sources of risk to that capital relative to its size.
1.1 Underwriting Leverage (Solvency Margin)
Net Written Premium / Reported or Adjusted Shareholders’ Funds
This is the classical analyst’s ratio for relating current underwriting risk to risk capital, and hence ‘pricing’ risk (the risk that premium rates charged prove inadequate). The greater the volume of retained premium to risk capital the greater the negative impact on that capital under-pricing could have.
In practice, since current year underwriting volumes are not known, the prior year number (i.e. as per the last accounts) is used as a proxy.
It is important to note that under-priced business leading to lower premium volume for a given amount of risk would actually make this ratio appear relatively better (and vice versa). Nonetheless it is the importance of the overall scale of underwriting to capital that it addresses and that leads to its very widespread use in non-life insurer analysis.
1.2 Reserve Leverage
Net Technical Reserves / Reported or Adjusted Shareholders’ Funds
This ratio indicates the potential impact that under-reserving on prior business would have on the risk capital. The greater the reserve leverage the greater the ‘hit’ to risk capital a given percentage of under-reserving would represent (without a capital injection to cover the required additional reserving).
It is important to note that this ratio is not an indicator of reserve ‘adequacy’, rather it highlights the extent to which the insurer’s existing capital can withstand a reserving problem IF one emerges.
1.3 Investment Leverage (asset risk)
(0.1*Lower Risk Liquid Investments + 0.1*Mortgages & Loans + Higher Risk Liquid Investments + Other Illiquid Investments + Market Value Adjustment) / Reported or Adjusted Shareholders’ Funds
The risk of invested assets obviously varies widely by asset class. To make the population of this ratio fit with what is commonly available in public balance sheets, Litmus has divided liquid assets into ‘higher’ and ‘lower’ risk categories, with the latter having only 10% of the impact on the ratio of the former.
Lower risk liquid investments would typically be regarded by insurance specialist credit analysts as:
Higher risk liquid investments would typically include:
However, Best does not differentiate between investment grade and non-investment grade/unrated bonds in the database the BLTR draws from. Since insurers would typically hold most (or all) of their bond portfolio in investment grade bonds we have treated the bond investment data from Best’s as being ‘low risk liquid investments’. Users should be conscious however that if this actually contains any material degree of non-investment grade/unrated paper then the investment leverage ratio will be understated.
In accounting regimes where the ‘fair market value’ of investments is not reported in the balance sheet, but is reported in notes to the accounts, Best’s capture this as a separate field and it is added into the calculation of both the numerator and the denominator. Its full inclusion in the numerator of the calculation reflects the assumption that, most typically, the larger part of the difference between ‘fair market’ and ‘book’ value would come from ‘higher risk’ investments.
The risk profile of mortgages and other loans can vary substantially but as an overall class they are generally regarded as ‘lower risk’ within insurance credit analysis models and treated as such in this ratio.
All other non-liquid investments are treated as ‘higher risk’ for the purposes of this ratio calculation.
Short-term deposits (generally defined as less than 1 year) with credit institutions are not typically reflected within an investment risk ratio and hence not included here. However, this assumption is dependent on the risk profile of the credit institution the exposure is with.
(Reinsurance Recoverables + Other Debtors – Reinsurance Deposits) / Reported or Adjusted Shareholders’ Funds
Non-recovery of monies owed has exactly the same 1:1 impact on the risk capital of the insurer as falls in investment values noted above.
For most insurers the primary source of monies due will most commonly be amounts due from reinsurers. Crucially this does not simply mean on claims already paid by the insurer but also on both claims notified but not paid, and on ‘incurred but not reported’ claims (IBNR). The latter can be the biggest source of credit exposure the insurer has to its reinsurers.
This risk includes both the inability of the reinsurer to pay and also its unwillingness to pay (i.e. ‘dispute’ risk).
Deposits held by the ceding re/insurer are therefore deducted from the numerator as these help offset this exposure. Other forms of protection (such as ‘collateral’ and other privileged claims on a reinsurer’s assets) are not typically sufficiently detailed or defined in published accounts for Bests to capture.
Non-reinsurance debtors can also be a material source of credit risk to an insurer and hence these are also included in the calculations.
2.Operating Performance ratios
While the capital ratios above help to address the apparent resilience of the current (latest) financial profile to absorb losses (underwriting or asset derived) that are not already reserved or accounted for, operating performance ratios address the nature and extent of operating profitability. Credit analysts consider current and historical performance as setting a key context for potential future performance. Future retained profits are typically seen by insurance credit analysts as the highest quality source of future capital strength.
Two performance ratios are shown in the BLTR. The first (combined ratio) reflects purely underwriting profitability, the second (operating ratio) adds in the impact of ‘operational’ investment income (see below).
Equity analysis would tend to also focus (or even primarily focus) on some form of return on equity (RoE) measure. However, whilst this is useful, it has less relevance to most credit analysts than the two ratios shown. This is because a RoE outcome is partly a function of how aggressively an insurer is prepared to trade (i.e. how much premium, reserve and asset risk they are happy to have vs. their risk capital base) and hence less of a pure view of the intrinsic profit generating ability of the business.
It is important to note that each of these ratios will be impacted if the reported results in the latest (calendar year) accounts gain from prior year reserve releases or are hit by the need to increase reserves on prior years’ business.
Each ratio is calculated as a 2-year average (assuming 2 years of data are available) to limit the impact of an abnormal single year of earnings.
2.1 Underwriting Profitability: the combined ratio
The 2-year average of : Loss Ratio + Expense Ratio
The loss ratio is calculated as:
Net Claims Paid and Outstanding / Net Earned Premium.
The expense ratio is calculated as:
Net Underwriting Expenses and Commissions / Net Written Premium.
Note: Insurance credit analysts vary in whether to use net earned or net written premium in the expense ratio. Litmus has chosen the latter route and the model calibrations and benchmarks reflect that approach.
The combined ratio is a primary method of observing the degree of underwriting profitability. Results below 100% typically indicate an underwriting profit, with the degree below 100% indicating the ‘margin’ within that.
2.2 Operating Profitability: the operating ratio
The 2-year average combined ratio (as per 2.1) minus the 2-year average of (Other Underwriting Income + Net Investment Income) / Net Earned Premium.
Net investment income excludes realised and unrealised gains and losses as these are typically seen by insurance credit analysts as not part of normal operating performance for most non-life companies.
Under normal economic circumstances, the ability to earn investment income on carried reserves increases the rating pressure on pricing in longer-tail business relative to shorter tail business.
Hence a focus on the combined ratio alone would be relatively too generous a measure of operational performance for companies with shorter tail vs longer tail books.
Accordingly, by subtracting the impact of operational investment income from the combined ratio, the operating ratio adjusts for this short/long tail portfolio effect, with expected lower combined ratios for shorter tail businesses being offset by lower expected operational investment income in the operating ratio outcome.
3.Liquidity (liquid asset reserve coverage)
Liquid Assets / Net Technical Reserves
An inability to be able to access sufficient liquid funds to meet obligations in a timely manner (even if technically solvent) can be both a regulatory and market-reputational crisis for an insurer.
It should be noted that for insurers with a significant exposure to longer tail lines this ratio will tend to overstate required near-term liquidity in terms of the need to pay claims (other than in response to catastrophe related losses, if those remain part of the insurer’s retention) unless there is a problem recovering monies from reinsurers for current claims in a timely manner. This latter risk is reflected in the credit risk ratio.
However, the degree of reserve coverage by liquid assets also provides an indirect indicator of the risk management flexibility a non-life insurer has in reacting to investment market changes. The ability to switch investments backing reserves into, for example, lower risk assets in reaction to difficult investment market conditions is likely to be enhanced by holding a high degree of liquid assets in the existing portfolio.
4.Reinsurance Utilisation (retention ratio)
Net Written Premium / Gross Written Premium
This ratio gives an indication of the extent to which a ceding insurer uses (and hence may fundamentally require) considerable amounts of reinsurance capacity relative to its retention. While for almost all insurers risk mitigation by purchasing reinsurance is a prudent step, ceding substantial percentages of gross written premium can expose an insurer to a greater risk of being a ‘price-taker’ in its negotiations with reinsurers (depending on reinsurance market conditions) or expose it to a fundamental business challenge if reinsurance capacity availability materially reduces.
While commissions received from reinsurers can be an attractive part of a primary insurer’s business model (especially if it has strengths in accessing business seen as attractive by reinsurers), this also exposes it to additional business risks in the event that its primary business lines become unattractive to reinsurers.
It is important to note that this ratio reflects only the aggregate degree of premium used in reinsurance purchasing; it does not address the nature or degree of the risk transfer purchased via reinsurance (which is rarely observable from public accounts and not shown within Best’s data).